One of the fundamentals of business valuation training is Revenue Ruling 59-60. Although published in 1959 with the express purpose to “outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes” it has been accepted by the federal courts in applications of fair market value across the board. This commentary introduces the main points of the revenue ruling, provides some insights from a historical perspective and comments on a recent publication regarding Revenue Ruling 59-60 and its application to Subchapter S corporations, limited liability corporations, and partnerships.
Main points of Revenue Ruling 59-60
A revenue ruling is an official interpretation by the IRS of the Internal Revenue Code, related statutes, tax treaties, and regulations. It is the conclusion of the IRS on how the law is applied to a specific set of facts. i] IRS employees are expected to follow Revenue Rulings. Revenue Rulings were written by IRS attorneys, were reviewed, and were made formal to assist the public on knowing how the IRS may look at a specific issue. In this case the emphasis is on how to value stock of closely held corporations where market quotations are not available for estate and gift tax purposes.
The revenue ruling is a must read for any business valuer. The revenue ruling provides Background, and Definitions, Approaches to Value, eight Factors to Consider, Weight to Be Accorded Various Factors, Capitalization Rates, and Restrictive Agreements commentary. The eight Factors to Consider are initially outlined in the commentary as:
(a) The nature of the business and the history of the enterprise from its inception.
(b) The economic outlook in general and the condition and outlook of the specific industry in particular.
(c) The book value of the stock and the financial condition of the business.
(d) The earning capacity of the company.
(e) The dividend-paying capacity.
(f) Whether or not the enterprise has goodwill or other intangible value.
(g) Sales of the stock and the size of the block of stock to be valued.
(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
These eight factors are elaborated on within the revenue ruling. I want to point out that the revenue ruling addresses in point (e) The dividend-paying capacity. Dividends are associated with C-corporations. Note that S-corporations, limited liability corporations, and partnerships do not pay dividends, but rather make distributions. This will be elaborated on below.
Insights from a historical perspective
This author led a team of PhD statisticians and economists in the research function of the IRS for four years and provided reports with the intention of improving voluntary compliance. With my background in business valuation the IRS began to include various ratios and concepts familiar to business valuers when analyzing corporate data. Researchers have no taxpayer identifiers but have access to all other return information. Researchers may also tie this information to other data sources. A byproduct of this research allowed filters to be developed in research that were used by examination to identify possible audits from outliers of this analysis. Working with the Statistics of Income questions arose related to Subchapter S corporations and C corporations. Historical files were explored include Revenue Ruling 59-60. The historical file indicated analysis of C corporations in the formulation of the Revenue Ruling, but had no information related to S corporations, limited liability corporations, or partnerships.
Public Law 85-866 establishing Subchapter S corporations became law on September 2, 1958.
The Statistics of Income for 1958-1959 Corporate Income Tax Returns with accounting periods ended July 1958-June 1959 provided this insight on page 7:
“The provisions of subchapter S are effective for taxable years beginning after December 31, 1957, and ending after date of enactment, September 2, 1958. To use the provisions of subchapter S for accounting periods beginning before September 2, 1958, an election had to be made within 90 days of that date. Owners of 44,000 businesses decided within the 90-day period to use the new provisions for accounting periods ended after September 2, 1958, and before July 1, 1959 (periods covered by this report).”
A question is whether the writers of Revenue Ruling 59-60 would have considered Subchapter S corporations when writing Revenue Ruling 59-60. In 1959 there were a least 391 revenue rulings written.[ii] Revenue Ruling 59-60 would likely have been published early in the year and likely in January or February of 1959. A revenue ruling has to be written and reviewed for approval before entering the public record. A likely timeframe for completion of these tasks would be on the order or 6 to 9 months. It would appear that the authors may not have been aware or elected not to include commentary on Subchapter S corporations when writing Revenue Ruling 59-60. There was nothing in the file related to S corporations.
It should be noted that the term dividend associated with a C corporation appears 24 times in Revenue Ruling 59-60. There is no mention of distributions associated with a S corporation and no mention of Subchapter S or any pass through entities in Revenue Ruling 59-60.
Comments on a recent publication regarding Revenue Ruling 59-60
This author wants to commend Z. Christopher Mercer with his publication entitled “What Revenue Ruling 59-60 Says (and Doesn’t Say) About Fair Market Value”. This publication was made available free of charge in April 2022. I have downloaded his 42 page paper and found it to be highly informative and useful for his target audience of attorneys and judges as a guide to fair market value. Mercer states on page 1 that “the revenue ruling is equally applicable to the valuation of businesses held in the form of S corporations, limited liability companies and partnerships.” I would concur that as a generalization this is true. However, from the information provided above I might propose that the authors had not fully considered pass through entities and the implications of taxes associated with these pass through entities at the time Revenue Ruling 59-60 was published.
There are those that believe there is no difference in value between a C corporation and a S corporation. That is a separate area of contention. The point of this commentary is that when Revenue Ruling 59-60 was published it would appear to this author that it was written specifically for C corporations. Many of the elements may be applied to S corporations, limited liability companies and partnerships, but it would appear those were not considered by the original authors.
What do you think?